Play Some Offense!

“Ok McGough, we’re tired of you and your team sounding all gloom and doom.” Don’t think I have not heard that from several people. But the sheer downside that remains in this space from a ‘Trend’ perspective (i.e. 3 points of margin erosion over 2-3 years) coupled with the market’s misalignment with economic reality, have supported a very bearish view. But as my colleague Keith McCullough has pointed out starting with his 10:59a.m. posting on 7/15, the ‘Trade’ is serving up a great opportunity for us to be selectively bullish, and ultimately capture volatility on both ends of the spectrum. To all you stock pickers out there – this is when you earn your keep!

In that context, here are the names I like, as well as those that pose the biggest risk.
FAVORITES
1. RL: Coming off an ‘investing mode’ period while the rest of retail was printing peaky margins. Now costs start to ebb when RL’s revenue starts to flow (Japan, handbags, dresses, Russia, leather goods, footwear to name a few initiatives). Numbers look very beatable, and cash flow trajectory is one of the best I can find in this group. Do I like valuation as much now given that so many other names have become so dang cheap? No. But the sustainability here is very impressive and numbers are low. I’ll take that, and I think the market will too.

2. TBL: The poster child for a company that invested in its business and took margins down when things got tough instead of cutting into muscle to keep margins high. I think that margins have hit bottom, and that this stock is a 2 year double.

3. FL: A massive industry shift over 4 years away from core athletic disproportionately hurt comps. Add on horrendous conversion and a boost in lower-margin Nike product as a percent of the mix, and margins went from 7% to 1%. Now performance trend is turning, and Under Armour will help on the margin. Layered over a lower cost structure and flexible lease terms, this much-hated name made it to my list of favorites.

4. LIZ: Management’s has a colossal task ahead. The good news is that cost cuts have been overinvested into the biz over the last two years. Now we’re at a point where either 1) LIZ harvests, 2) LIZ cuts, or 3) LIZ restructures massively. With cliff vesting for options in ’09 to jump start near term performance, I like how this is shaping up.

5. PSS: Not a name I’ve spoken about much recently, but one I like. Coming off a horrific year for the industry, an ill-timed acquisition, and a recent cash-draining lawsuit ruling. Not good for a zero square footage growth retailer. But all my math still tells me that this company can take up mix to the mid-teens from low-teens today. Also, with such broad distribution and with an arsenal of brands including Sperry, Keds, and Saucony, I think that PSS has the goods to be one of the winners in the new footwear landscape.

6. CRI: After being bearish on CRI’s model for a while, I pulled a 180 on CRI after the recent management change. Once earnings come down again this should shape up to be a good one.


LEAST FAVORITE
1. WRC: Yes, it’s been a crowded short. But insiders are selling, inventory/sales spread is peaking, margin compares are getting tough, cotton costs are rising (vis/vis CK Underwear), and a cleaner P&L is making it tougher for WRC to sandbag. Not good.

2. ADI: Tough sales comps in ’09 due to European Championships ’09 and Beijing Olympics come in conjunction with frontal UA assault, Nike response, and almost zero consumer interest in Reebok. Add on extremely tough product cost increases and big FX risk, and it equates to being at the top of my short list.

3. GIL: One of the most misunderstood, and overly liked, companies in retail. A well executed offshoring strategy allowed GIL to take share and dominate its core category while improving margins by 30%. Now share is tapped out, and the strategy is changing to into a less defendable business. Sales are slowing, GM is tapped out, and SG&A is way too low to support meaningful growth. I think that every line item of this P&L is trending down on a multi-year basis.

4. VFC: I actually like the company. But sales growth is decelerating, margins are getting pinched, and capital spending is headed higher. Ultimately, it is very tough to make the leap in assumptions to get to a trajectory where cash flows don’t roll. Plus, it’s tough to argue with the stats that less than 5% of the shares are held short, the ‘buy rating ratio’ is at an all time high of 67%, and numbers don’t appear to be a slam dunk.

5. SKX: We’re hitting the end of a 4-year period where a shift towards fashion and away from performance footwear combined with sourcing tailwinds and FX benefit took up margins. Now biz is turning. Inventory is showing up in bad places (Goody’s), and management is selling stock. I think margins are cut by at least a third.

6. GES: I think that the margin trajectory at GES is unsustainable. While one of the better apparel companies, I think hindsight in 12 months will show lack of brand reinvestment at the top of the cycle. FX risk here is scary.

7. DKS: UA comp cycle + =rock solid consumer + easing competitive landscape + high vendor discounts = hidden impact from aggressive lease structure over the past three years. Now every one of those items has turned – except for the aggressive lease terms. Next Q looks ok, but DKS numbers should come down again. This is one I consistently revisit on pops, including a potential rally around a sandbagged 2Q.

8. PVH: A perennial favorite for the investment community, I can’t get over the risk of a 3-400bp deceleration in menswear sales – the likely fallout from the sheer magnitude of Wall Street jobs being cut (mens dress shirts and ties represent almost 50% of cash flow).


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